CFA 2018 Quest bank Corporate Finance 01 Capital Budgeting

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Test ID: 7440537

Capital Budgeting

Question #1 of 62

QuestionID:462567

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ᅚ B)

ᅞ C)

Question #2 of 62

QuestionID:462570

ᅚ A) ᅞ B) ᅞ C)

Questions #3-8 of 62

Which ofthefollowingstatementsabout mutually exclusiveprojects with unequallivesisleastaccurate?

Forcomparing mutually exclusive projects with unequal lives, replacement chain analysis leads to the same decision as obtained bycalculating the equivalent annual annuity.

In comparing mutually exclusiveprojects with unequallives, youshouldalways choosethe project which hasthe highest NPV.

Mutually exclusiveprojectssometimes havelonganddifferentlives, which makesapplying the replacement chain methoddifficult becausethelowest commondenominator is very large. Theequivalentannualannuity isasubstitute methodthatusestheannuity conceptto valuea project's cash flows.

Explanation

In comparing mutually exclusiveprojects, replacement chainor equivalentannualannuity analysisshould beusediftheprojects have unequallivesand can be replicated.Therefore, you willnotalways choosetheprojectthat hasthe highest NPV,ifaproject with alower NPV can be replicatedand resultsina higher NPV over thesameperiodoftimeastheprojectthat hasalonger timeperiod.

Intheabsenceof capital rationing,afirm shouldtakeonthe mostprofitableinvestmentsfirstand keepexpandingtheir investmentstothe point wherethe marginal:

return of the last investment equals the marginal cost of capital. costofdebtequalsthe marginal costofequity.

returnofthelastinvestmentequalsthe risk free rate.

Explanation

Thefirm willgenerally investinthe mostprofitableprojectsfirst. Subsequentprojects will havelower expected returns.Astheamountof capitalincreases,the marginal costof capitaltendsto rise.Thefirm shouldinvestinnew projectsuntiltheexpected returnisequaltothe marginal costof capital.

Zelda Haggerty was recently promotedtoproject manager at VerbanAutomation,a maker ofindustrial machinery. Haggerty's

firsttask asproject manager istoanalyze capital-spendingproposals.

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Question #3 of 62

Question ID: 462574

ᅚ A)

Theinitialoutlay tothe builder would be $85 millionfor the building. Verban wouldspendanother $20 millionon

specializedequipmentinthefirst year.

Thefactory wouldopenupnew marketsfor Verban'sproducts. Productionshould begin July 1ofthesecond year. Verban'stax rateis34percent.

Verbanexpectsthefactory togenerate $205 millioninannualsalesstartinginthethird year, with halfofthatamountinthe second year.

Attheendofthesixth year, Verbanexpectsthe market valueandthe book valueofthe buildingto be worth $35 million,

andthe market valueandthe book valueoftheequipmentto be worth $3.25 million.The building will bedepreciatedover 6 years.Theequipment will bedepreciatedover 5 years.Depreciationexpense will be $8.33 millionin Year 1and $11.68 in Years2through 6.

Cash fixedoperating costsareexpectedto be $65 milliona year oncethefactory startsproduction. Variableoperating costsshould be40percentofsales.

New inventoriesarelikely to boost working capital by $7.5 millioninthefirst year ofproduction. Verban's costof capitalfor thefactory projectis14.3percent.

Verban's chiefofoperations, Max Jenkins,attachedanote containingsomeof histhoughtsabouttheproject. His comments arelisted below:

Comment1: "Wespent $5 millionupfrontonanexclusive,10-year maintenance contractfor allofour equipmentinAsia two yearsago, beforeanearlier project was canceled. Your budgetshould reflectthat."

Comment2: "SomeAsian clientsarelikely toswitch over totheequipmentfrom thenew factory.They accountfor about

$5 milliona year insalesfor the U.S.division. Your budgetshould reflectthat."

Comment3: "Iexpect variable coststotakeaone-time hitin Year 1,as weshouldplanfor about $1.5 millionininstallation

expensefor the manufacturingequipment."

Comment4: "We boughtthelandallocatedfor thisfactory for $30 millionin1998.That money islongspent,sodon't worry

aboutincludingitinthe budgetanalysis."

Haggerty isunimpressed with theadviceshe receivedfrom Jenkinsand calculates cash flowsandnetpresent valuesusing numbersfrom thefactsheet withouttakingany oftheadvice. Sheassumesallinflowsandoutflowstakeplaceattheendof

the year.

Verbanisalso considering buildingtwosmaller,outdatedfactories,projectsfor which the costof capitalis14.3percent.Both ofthe remodeledfactories would be replacedattheendoftheir usefullivesandtheir cash flowsareasfollows:

Project Initial outlay Year 1 Year 2 Year 3 Year 4 Year 5

A −$30 million $15 million $17 million $28 million -

-B −50 million $12 million $15 million $19 million $22 million $32 million

Verbanis willing to pursueoneof the smaller new factories butnot both. Haggerty decides which project makes the most

senseand prepares models and recommendations for Verban's executives. Haggerty is concerned that her budgeting calculations donotaccurately reflectinflation, and would liketo modify her models to reflectexpected inflationover thenext

five years. Sheis uncertain, however, how this would affect WACC, IRR, and NPV.

If Haggerty decides to properly allocatethe maintenance, land-purchase, and equipment-installationexpenses Jenkins claimed were connected with thenew factory project, which of the following numbers onthe capital-budgeting model will be

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Question #6 of 62

Question ID: 462577

ᅞ A) ᅞ B) ᅚ C)

Question #7 of 62

Question ID: 462578

Question #8 of 62

Question ID: 462579

ᅞ A)

Inflation causes the WACC toincrease, so Statement2is false. Becausethe WACC reflects inflation, future cash flows must

beadjusted toavoid a downward bias, so Statement1is true. Both the NPV and theIRR willtend to declineif cash flows are

notadjusted - Statements 3and 4are false. (Study Session7, LOS 22.b)

Jenkins adviceis CORRECT with respectto: Comment 4 only.

Comments 1and 2. Comment2only.

Explanation

Potential cannibalizationof sales should be reflected inthe budget, so Comment2is correct. The maintenance contract

represents a sunk costand should not beincluded inany capital budgeting, so Comment1is incorrect. Sincetheland could beused for another purpose, it represents anopportunity cost. The valueof theland should be reflected inthe budget, so Comment4is incorrect. Installation costs add tothe purchase priceof theequipment, increasing its depreciable basis over the lifeof theitem. They should not be charged as a variable cost, so Comment3is incorrect. (Study Session7, LOS 22.a)

Ignoring Jenkins's comments, in Year 2of thenew factory project, cash flows will be closest to: $19.35 million.

$23.32 million. $15.61 million.

Explanation

Verban begins selling products inthe second half of Year 2, so sales and expenses are half of whatis projected onanannual

basis. $102.5 millionin sales, $32.5 millionin fixed costs and (102.5 × 0.4) = $41 millionin variableexpenses yield pretax cash flows of $29 millionand after-tax cash flows of $19.14 million.

Depreciation = $11.68 million (given)

In Year 2, the first year of production, Verbanalsoadds $7.5 millionin working capital.

Cash flow = cash from factory operations + depreciation × t − additions to working capital = $15.61 million. (Study Session7, LOS 22.a)

Haggerty is using theequivalentannualannuity method, depending only on data from the cash-flow estimates for the

remodeling projects. Which project should Haggerty recommend, and which of the following is closesttothe difference

betweenthat project's EAA and thatof theother project? Project _E_AA_d_i_ff_e_r_e_nc_e

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ᅚ B) ᅞ C)

Questions #

9 -14 of 62

Question #

9 of 62

Question ID: 462541

Question #10 of 62

Question ID: 462542

A $2.34 million

B $1.23 million

Explanation

Inorder toanswer this question, we must determinethe NPV for both projects: Project A: NPV = 14.8865

Project B: NPV = 13.9963

Project A: PV = 14.8865; N = 3; I = 14.3; EAA= PMT = 6.44 Project B: PV = 13.9963; N = 5; I = 14.3; EAA = PMT = 4.10 (Study Session7, LOS 22.c)

Jayco,Inc.is consideringthepurchaseofanew machinefor $60,000that will reduce manufacturing costs by $5,000annually.

Jayco willusethe MACRS accelerated method (5 year asset)todepreciatethe machine,andexpectstosellthe machineattheend

ofits6-year operatinglifefor $10,000. (Thepercentagesfor the5-year MACRS classare, beginning with year 1andending with year 6,20%,32%,19%,12%,11%,and6%.)

Thefirm expectsto beableto reducenet working capital by $15,000 whenthe machineisinstalled, but required working capital will returntotheoriginallevel whenthe machineissoldafter 6 years.

Jayco's marginaltax rateis40%,andthefirm usesa12% costof capitaltoevaluateprojectsofthisnature.

Whatisthefirst year's modifiedaccelerated cost recovery system (MACRS)depreciation?

$15,000. $10,000. $12,000.

Explanation

Thefirst year MACRS depreciationequals60,000 × 20%,or 60,000 × 0.2 = $12,000. (LOS 25.a)

Thefirst year'sincrementaloperating cash flow isclosestto?

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Question #11 of 62

Question ID: 462543

ᅞ A) ᅚ B) ᅞ C)

Question #12 of 62

Question ID: 462544

Question #13 of 62

Question ID: 462545

ᅞ A) ᅚ B)

ᅞ C) Explanation

Thefirst year'sincremental cash flow equalstheafter-tax impactofthe $5,000operatingsavingsandthedepreciationtax shield,or (5,000)(0.6) + (60,000)(0.2)(0.4) = 3,000 + 4,800 = 7,800.

(LOS 25.a)

Theinitial cash outlay isclosestto:

$57,000. $45,000. $75,000.

Explanation

Initial cash outlay = up-front costs (including costofthe machine)and changesin working capital. Here,thepriceofthe machineis 60,000andthe working capitalinitially decreases by 15,000 (which isasourceoffunds).Thus,theinitial cash outlay = 60,000 cost−

15,000 working capital = 45,000. (LOS 25.a)

Whatistheproject'sterminal year after-tax non-operating cash flow?

$21,000. ($4,000). ($9,000).

Explanation

Terminal cash flow = [salvageprice] − (tax rate) × [salvageprice− book value] ± reversalof changein working capital. = 10,000− (0.40) × (10,000−0)−15,000 = 10,000-4,000−15,000 = −9,000.

(LOS 25.a)

If the NPV using MACRS depreciation rates for this projectis negative, changing the depreciationtoa straight-line method will

resultinthe signof the computed NPV being:

different; as the NPV increases and the NPV is now positive.

the same; as the NPV decreases and is less thanthe NPV computed under for tthe

MACRS method.

the same; depreciationis non-cash and does notaffectthe NPV computation.

Explanation

Anaccelerated depreciation method such as the MACRS will resultina higher NPV compared tothe NPV using a straight-line

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Question #14 of 62

Question ID: 462546

Question #15 of 62

Question ID: 485741

ᅞ A)

project, straight-line depreciation would have madethe NPV evenlower and henceit will remainnegative. (LOS 25.a)

The most appropriate discount rateto beused for capital budgeting would be:

the firm's WACC.

the project's hurdle rate.

yield to maturity onthe bonds issued to financethe project.

Explanation

Project's hurdle rateis theappropriate discount rate reflecting the project's risk. Firm's WACC reflects the firm's risk and not the project's risk. Costof debtissued to financethe project reflects theoverall risk of the firm and hence would also be

inappropriate.

ErwinDeLavall,the Plant Manager of Patch GroveCabinets,istryingtodecide whether or notto replacetheold manuallathe machine with anew computerizedlathe. Hethinksthenew machine willadd value, butisnotsure how to quantify hisopinion. Heasks his colleague,Terri Wharten,for advice. Wharten'sson just happensto bea LevelIICFA candidate.DeLavalland Whartenprovidethe

followinginformationto Wharten'sson:

CompanyAssumptions:

Tax rate:40%

Weightedaverage costof capital (WACC):13% NewMachineAssumptions:

Costof (includesshippingandinstallation): $90,000 Salvage valueatendof year 5: $15,000

Depreciation Schedule: MACRS 7-year, with depreciation ratesin years1-5of14%,25%,17%,13%,and 9%, respectively Purchase willinitially increase currentassets by $20,000and willincrease currentliabilities by $25,000

Impacton OperatingCash Flows Years1-5 (includesdepreciationandtaxes): $16,800 (assumeequalamounteach year for simplicity)

OldMachineAssumptions:

Current Value: $30,000

Book value: $13,000.Book valueand market value will be zeroattheendoffive years. Which ofthefollowing choicesismostcorrect? Patch GroveCabinetsshould:

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ᅞ B)

ᅚ C)

replacetheoldlathe with thenew lathe becausethenew one willadd $10,316tothefirm's value.

replacetheoldlathe with thenew lathe becausethenew one willadd $3,760tothefirm's value.

Explanation

The valuation methodthatshowstheproject'simpactonthe valueofthefirm isnetpresent value (NPV).To calculate NPV, weneedto

determinetheinitialinvestmentoutlay,theoperating cash flows,andtheterminal year cash flows.Then, wediscountthe cash flowsat the WACC.The calculationsareasfollows:

Step 1: Initial InvestmentOutlay:

= costofnew machine + proceeds/loss from old machine + changeinnet working capital (NWC) = -$90,000 + $30,000- $6,800 + $5,000 = -$61,800 (cashoutflow)

Detailsof calculation:

xCostofnew lathe = $90,000outflow xSaleof Old Machine:

o Salesprice = $30,000inflow o Tax/tax credit: $6,800outflow

= (Salesprice- book value)*(tax rate) = (30,000-13,000)*0.4 xChangein NWC = $5,000inflow

o _'NWC = ' currentassets-_' currentliabilities = 20,000-25,000 = -5,000 (adecreasein working capitalisasourceoffunds)

Step 2:Operating Cash Flows (years 1-4): Given as $16,800 inflow Step 3: Terminal Value:

= year 5 cash flow + return/useof NWC + proceeds/lossfrom disposalof new machine + tax/tax credit = $16,800 - $5,000 + $15,000 + $1,920 = $28,720 inflow

xYear 5 cash flow (given) = $16,800 inflow

xWorking capital (reverse 5,000 initial inflow) = $5,000 outflow xSaleof New Lathe:

o Salesprice = $15,000 inflow o Tax/tax credit: $1,920 inflow

= (Salesprice- book value)*(tax rate)

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Question #17 of 62

QuestionID:462572

Question #18 of 62

QuestionID:462564

ᅞ A)

ᅚ B)

ᅞ C) Explanation

economic income = cash flow −economic depreciation where:

economic depreciation = (beginning market value−ending market value) Economic income isnotthesameaseconomic profit.

Jayco,Inc. isevaluatingtwo mutually exclusive investmentprojects.Assume both projects can be repeated indefinitely. Printer A hasanetpresent value (NPV)of $20,000over athree-year lifeand Printer B hasa NPV of $25,000over afive-year life.The

projecttypesareequally risky andthefirm's costof capital is12%. What istheequivalentannualannuity (EAA)of ProjectA

and B?

ProjectA Project B

$7,592 $6,935

$8,327 $6,935

$8,327 $5,326

Explanation

Printer A: PV = 20,000, N = 3,I = 12,FV = 0,Compute PMT = 8,327 Printer B: PV = 25,000, N = 5,I = 12,FV = 0,Compute PMT = 6,935. (Note: take the highest EAA,PrinterAin this example)

Which ofthefollowingstatements regarding inflation isCORRECT? Inflation:

is already present in the future cash flows therefore they need no further adjustment.

is built intothe weightedaverage costof capital (WACC)andthusthenetpresent value (NPV) isadjustedfor expected inflation.

causesthe weightedaverage costof capital (WACC)to increaseandthepresent valueofthe cash flowsto increase.

Explanation

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Question #22 of 62

QuestionID:462588

8% andtax rateof30% totheproject. Huang'ssupervisor hasasked him touse both theeconomic incomeandeconomic profitapproachestoanalyzetheproject.After completing hisanalysis, Huang makesthefollowingstatementsto his supervisor.

Statement1: Inthefirst year oftheproject's life,theeconomic incomeexceedstheeconomic profitgeneratedfrom theproject. Statement2: Thediscount rateappliedtotheeconomic profitto calculatetheproject'snetpresent value (NPV) will be identical

totheeconomic rateof returnearned by theprojecteach year.

How should Huang'ssupervisor respondto hisstatements?

Agree withboth. Agree with neither. Agree with oneonly.

Explanation

Toanswer thefirst question, weneedto calculatetheeconomic incomeandeconomic profitfor thefirst year oftheproject. Economic income istheafter-tax cash flow plusthe change in market valuefor an investment.

Cash flow = operating income (1−T) + depreciation = $80(1−0.30) + $50 = $106 million.

Nextdeterminethe current market valueoftheprojectas: (106 / 1.08) + (106 / 1.08 ) + (106 / 1.08 ) = $273.17 million.The valueafter Year 1 = (106 / 1.08) + (106 / 1.08 ) = $189.03 million.The change in market value = (273.17−189.03) = $84.4 million.Theeconomic income is $106− $84.4 = $21.86 million.

Economic profit = NOPAT− $WACC = EBIT(1− T)− $WACC Economic profit (Year 1) = $80(1−0.30)−0.08($150) = $44 million

Huang'ssupervisor shoulddisagree with thefirststatementastheeconomic profitof $44 millionexceedstheeconomic incomeof $22 million.

Huang'ssupervisor shouldagree with thesecondstatement.Thediscount rateappliedtotheeconomic profittodeterminethe

project's NPV isthe WACC.Theeconomic rateof returnusingtheeconomic incomeapproach will beequaltothe WACC,so the ratesare identical. We cantakethefirst year'seconomic incomedivided by the market valueoftheprojectandseethat theeconomic rateof return isthesameasthe WACC. ($22 / $273) = 0.08,or 8%.

MichaelFullen isdiscussingtheevaluationof capital budgetingprojects with his coworker,KatinaKatzenmoyer. During conversation,Katzenmoyer makesthefollowingstatements regardingthedeterminationof realoption values:

Statement1: For independentprojects,ananalyst mustdeterminea valuefor the real optionthat isseparatefrom theproject regardlessofthe profitability oftheproject.

Statement2: Abandonmentoptions can be valuable, butshouldonly beexercised whentheabandonment value isgreater thanthediscounted present valueofthe remaining cash flowsoftheproject.

Arethestatements made by Katzenmoyer correct?

2 3

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Question #23 of 62

QuestionID:462600

Question #24 of 62

QuestionID:462593

ᅞ A)

Both are incorrect. Only one is correct. Both are correct.

Explanation

Fullenshoulddisagree with Katzenmoyer'sfirststatement.The valueofa realoption isalwayspositive.For an independent

project, iftheproject isalready profitable,a manager canaccepttheprojectsimply knowingthatthe realoption willsimply add totheprofitability withoutdeterminingaseparate valuefor theoption.

Fullenshouldagree with Katzenmoyer'ssecondstatement.Anabandonmentoptionshould beexercised whenthe

abandonment valuefor aproject isgreater thanthediscountedpresent valueofthe remaining cash flowsfrom theproject.

Paul Ulring,Chief Executive Officer ofArlington Machinery, hasasked SaraTrafer aboutthe benefitsofusinga variety of valuation modelsfor evaluating capitalprojects.In responseto Ulring's questions,Trafer makesthefollowingstatements:

Statement1: Theeconomic profit, residual income,and claims valuation methodsof valuationshouldall result inthesame valuationfor anasset or project,despitetheuseofdifferentdiscounts rates inthe calculations.

Statement2: The claims valuationandeconomic profit valuation models both include cash flowsthat will flow todebt holders,andthe costof debt isafactor in both calculations.

Which isCORRECT regardingTrafer'sstatements?

Both are correct. Both are incorrect. Only one is correct.

Explanation

Trafer'sfirststatement is correct.Intheory,allthreeofthedifferent valuationapproachesshouldleadtothesame result, despitetheeconomic profit methodusingthe WACC,the residual income methodusingthe costofequity,andthe claims valuationapproach separately usingthe costofdebtand costofequity asdiscount rates.Trafer'ssecondstatement isalso correct.The claims valuationapproach looksat cash flowstoequity holdersanddebt holdersseparately, whiletheeconomic profit methodlooksat cash flowsfrom theperspectiveofallsuppliersof capital,sodebt holders' concernsare included in both methods.Also,thediscount rateused with theeconomic profit method isthe WACC, whilethe claims valuationapproach considersthe costofequity andthe costofdebtseparately,sothe costofdebt isafactor in both calculations.

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ᅚ B)

ᅞ C)

Question #25 of 62

QuestionID:462587

Question #26 of 62

QuestionID:462563

ᅚ A)

ᅞ B)

Takingonthepetprojectsof management withoutgoingthrough the complete capital budgetingprocess.

Includingoverhead costs inthetotal costofa capitalproject.

Explanation

Petprojectsthat influential managers wantthe company to invest in will ideally receivethesamescrutiny received by other investments.Another potential concern with management'spetprojects isthatoverly optimistic projections will makethe

projectappear moreprofitablethan it really is. NotethatusingIRR for mutually exclusiveprojects willtendtosteer

managementtowardsmaller,shortterm projects with high IRRsand may notlead managementtothesamedecisionasthe moreappropriate NPV method. Overhead costsareoftendifficulttoestimate, butshould be included inthe costofa capital project.

Takamura Motors isevaluatinganew pieceofequipmentthat willautomatically installpower windows in cars comingoffthe

productionline.Theequipment cost is $3.5 million,andthefirm estimatesthatthepresent valueoftheannual costsavings

from installingtheequipment is $2.8 million.Theproduction manager isalso consideringpurchasinga modulethat willallow theequipmentto beusedfor Takamura's SUV production.Theadditional module representsa realoption with a costof $1.1 milliondollars.Theproduction manager estimatesthataddingthe module wouldgiveTakamura costsavingsofanadditional $2.0 million.

What istheprofitability oftheproject beforeandafter consideringthe realoption? Before After

-$700,000 $200,000

-$700,000 $1,800,000

$1,300,000 $200,000

Explanation

Theprofitability oftheproject before consideringthe realoption isthedifference betweenthe costsavingsandthe costofthe equipment,or 2.8-3.5 = -$700,000.

Theprofitability oftheprojectafter consideringthe realoption = NPV (basedonprojectalone)- costofoption + valueof option.The costoftheoption is $1.1 million, whilethe valueoftheoption is $2.0 million. Profitability after option = -0.7-1.1 + 2.0 = $200,000.

With respectto capital budgeting,expected inflation isaccountedfor inanetpresent value calculation by:

Adjusting expected cash flows and using a nominal WACC in response to changes in inflation.

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ᅞ C)

Question #27 of 62

QuestionID:462590

Question #28 of 62

QuestionID:462562

Excluding inflationfrom the calculationofthe WACCand instead inflatingtheexpected cash flows.

Explanation

Anominal WACC includeseffectsof inflationsothe cash flowsshouldalso beadjustedfor inflation (i.e.,should benominal cash flows).

SharonKelley and Joyce Weningarediscussingpotential capitalprojectsfor theFlagstaffCorporation.Kelley is concerned

about makingerrors inthe capital budgetingdecision makingprocessand wantstotakenecessary stepstoavoidsuch errors. In responsetoKelley's concerns, Wening makesthefollowingstatements:

Statement1: Weshouldavoid includingfactorssuch as managementtimeand informationtechnology supportsincethesearesunk coststhat shouldnot beattributedtotheproject.

Statement2: Once we havedeterminedasetofprofitableprojectoptions, weshouldstop consideringother alternatives inorder tofocusour resourceson makingsurethat wearenotomitting relevant cash flowsor double counting cash flowsfor our existingsetofprojects.

Both are incorrect. Both are correct. Only one is correct.

Explanation

Wening'sfirststatement is incorrect. Overhead costsaredifficult quantify, butproject costsshould includeany overhead costs

thatareattributabletoaproject. Wening'ssecondstatement isalso incorrect.Failureto consider investmentalternatives isa major capital budgetingpitfall. Generatinggood investment ideas isthe most importantstep inthe capital budgetingprocess. Managersneedto makesurethey arenotavoidingthe considerationof "better" projectssimply becausetheexistingproject under consideration is "good."

An increase inexpected inflation willgenerally:

decrease the weighted average cost of capital (WACC). leave weightedaverage costof capital (WACC)unchanged. increasethe weightedaverage costof capital (WACC).

Explanation

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Question #2

9 of 62

QuestionID:462599

Charles Waller,afinancialanalystfor Vandon Pharmaceuticals, isevaluatingapotential capitalprojectfor thefirm. Waller's

favorite capital budgetingapproach isthe residual income method, which hedecidestousefor thisproject.Inorder to help with hisanalysis, Waller has compiledfinancial information concerningtheprojectfor 2006.

Pr

oje

c

t I

n

c

o

m

e

S

t

a

te

m

e

n

t

200

6

Revenues $56,000

Variable Expenses $25,800

Fixedexpenses $6,000

Depreciation $8,000

EBIT $16,200

Interestexpense $5,000

EBT $11,200

Taxes (40%) $4,480

Net Income $6,720

Pr

o

j

e

c

t

Bala

n

c

e

Sh

eet

2005

Costof Project $80,000

Total Assets $80,000

Project Financing

Debt $32,000

Equity $48,000

Total Liabilities and Equity $80,000

Vandon Pharmaceuticals hasanafter-tax costofdebtof6.0% anda costofequity of12.0%. Vandon'starget capitalstructure is60% equity and40% debt.Basedon Waller'sinformation, whatisthe residualincomefor 2006,and whatistheproper

discountfor Waller touse whenfindingthe NPV oftheinvestment? Residualincome Proper discount rate

$960 12.0%

$960 9.6%

$5,760 9.6%

Explanation

Residualincome = Netincome-equity charge

where:

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Question #30 of 62

QuestionID:462581

ᅞ A)

ᅚ B) ᅞ C)

Question #31 of 62

QuestionID:462571

ᅚ A)

ᅞ B)

ᅞ C)

Question #32 of 62

QuestionID:462592

ᅞ A)

ᅚ B) ᅞ C)

RI = NI- k BV = $6,720- (0.12 × $48,000) = $6,720-5,760 = $960

The residualincome method concentrateson returnstoequity holders.Assuch,theproper discount ratetouse when determiningtheproject NPV isthe required returnonequity.

Which ofthefollowingstatementsaboutsensitivity analysisisleast accurate?

Sensitivity analysis alters a single independent variable to determine the impact on the output variable.

Sensitivity analysisstarts with the best-casescenario.

Thesteeper theslopeofthe NPV versusthe variable,the moresensitivetheoutput

variableistoa changeintheinput variable.

Explanation

Insensitivity analysis, youstart with the "base-case" scenario.Inthis case, youusethe company'sprojected cash flowsasthe inputsto calculatethenetpresent value (NPV)ofaproject. Hopefully,supportersofaprojectareproviding realistic

information,although it may beontheoptimistic side.Ina "best-case" scenario, revenues would beexcessively high, while expenses would beexcessively low.

Which ofthefollowingstatementsabouttheequivalentannualannuity approach for capital budgetingisleast accurate? A 5-year project has a NPV of $2,000, if the firm's cost of capital is 10% the

equivalent annual annuity is $725.

When comparing mutually exclusiveprojects with unequallives, replacement chain analysis yieldsthesamedecisionastheequivalentannualannuity method. The replacement chainapproach assumesthatitispossibleto make continuous

replacementseach timetheasset'slifeends.

Explanation

Calculating EAA resultsin [i = 10,n = 5, PV = -2,000] PMT = 528,not725.

Which ofthefollowingisleast likelyto causeaproblem whenanalyzinga capital budgetingproject?

Using the firm's weighted average cost of capital for the discount rate on all projects.

Incorporatingactionstaken by competitorsinthe capital budgetinganalysis. Basinginvestmentdecisionsontheimpactonearningsper share.

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Question #33 of 62

QuestionID:462589

Question #34 of 62

QuestionID:462585

ᅚ A)

ᅞ B)

ᅞ C) Explanation

Oneofthe commonpitfalls whenanalyzing capitalprojectsisnotincorporatingeconomic responsesfrom competitors.

Economic responsestoaninvestmentoftenaffectprofitability.

Notethat managers who makedecisions basedonshort-term EPS considerations may failto consider projectsthatdonot

boostaccountingnumbersintheshort-run, butareinthe bestlongterm interestsofthe business.Thediscount ratefor a projectshould beadjustedfor theproject's risk.

Spencer Charlson, Executive Vice Presidentfor PWKDesign,is consideringpurchasinganew computer system for thefirm. Charlson believesthat PWK would benefitfrom purchasingthesystem now, butalsoisawarethat Macroware,asoftware developer is comingout with anew operatingsystem that willavailableinthree months.Charlsonisunsure whether or notthe new operatingsystem would help PWKanddecidesto waituntilthenew operatingsystem comesout before makinga purchase.The computer system projectCharlsonisevaluating would bebest describedas havinga(n):

fundamental option.

flexibility option. timingoption.

Explanation

Timingoptionsallow a company todelay aninvestment with the hopeof having better informationinthefuture.Delayingan investmentand basingthedecisiononthe better informationgained by waiting may improvethe NPV oftheoverallproject.

Which ofthefollowingstatementsismost accurate?

In a graphical depiction of sensitivity analysis, the project with the steeper line

would be considered most risky, because a small error in estimating a variable, such as unit sales, will produce a large error in the net present value's

prediction.

A company thatdoesnotadjustthediscount ratefor differencesinproject risk islikely

toacceptanexcessivenumber oflow risk projects.

Thefinancial manager ofalarge corporationshould view standalone risk as most important becauseofitsimpactondebt capacity, credit worthiness,and job stability.

Explanation

Thesteeper thesensitivity analysisprofile,the moreimportantitistoaccurately forecastthat variable'struelevel.Financial

managersaretypically mostsensitiveto corporate,or withinfirm risk.Those companiesnot reducing required returnsfor

(19)

Question #35 of 62

QuestionID:462580

Question #36 of 62

QuestionID:462594

Which ofthefollowingsimulationtechniques computesas many as1,000netpresent values, basedon multiple valuesfor

each cash flow?

Monte Carlo simulation. Scenarioanalysis.

Sensitivity analysis.

Explanation

Through the computationof multiplenetpresent values, MonteCarlosimulationprovidesinsighttothepossibledistributionof netpresent valuesarisingfrom aproject. Scenarioanalysis,ontheother handfocusesonthe worst case, best case,and base

case. Sensitivity analysisinputs could be modified1,000times, buttypically only one variableis changedatatimefrom the

base casescenario.

FirehouseCompany isinvestingina 300 millionprojectthatis beingdepreciatedonastraight-line basisover atwo-year life

with nosalvage value.Theproject willgenerateoperatingearningsof 130 millioneach year for thetwo years.The required

rateof returnfor theprojectis10% andFirehouse'stax rateis30%. WhatisFirehouse'seconomic incomefor years1and2? Year 1 Year 2

-20 -20

61 76

42 22

Explanation

Notethatthis questionisaskingabouteconomic income,noteconomic profit. First,determinetheafter-tax cash flow for Years1and2as:

Cash flow = operatingincome (1-T) + depreciation = 130 (1-0.30) + 150 = 241

Next,determinethe current market valueoftheprojectas:

Market value = (241 / 1.10 ) + (241 / 1.10 ) = 418; market valueafter year 1 = (241 / 1.10 ) = 219

Constructingatable, weseethattheeconomic incomefor years1and2are 42and 22 respectively. Notealsothatthe economic rateof returnisequaltothe required returnontheproject.

Year1 Year 2

Beginning market value 418 219

Ending market value 219 0

Changein market value -199 -219

After-tax cash flow 241 241

(20)

Question #37 of 62

QuestionID:462561

Question #38 of 62

QuestionID:462597

Questions #3

9 -44 of 62

Economic income 42 22

Economic rateof return 10% 10%

Financialleverage would NOT beincreasedifafirm financeditsnextproject with:

preferred stock.

bonds with embedded calloptions.

commonstock.

Explanation

Financialleverageisthe resultoffinancingassets with fixedincomesecuritiessuch as bondsor preferredstock. Each ofthese alternatives hasa requiredpayment componentthatincreasesthe risk ofthefirm beyondthatarisingsolely from business

risk.

JamesCaseand Erica Gallardoare consideringdifferences betweenaccountingincomeandeconomic income when evaluating capitalprojects.Case makesthefollowingstatementsto Gallardo:

Statement1: Oneofthe main reasons why accountingincomeandeconomic income willdiffer isthatinterestexpenseissubtracted when calculatingaccountingincome, butisnot considered when computingeconomic income.

Statement2: Another reason why accountingincomeandeconomic income may differ isthataccountingdepreciationis basedonoriginal costs whileeconomic depreciationis basedon market values.

Gallardo considers both ofCase'sstatements. Gallardo wouldfind which statementsCORRECT?

Only one is correct.

Both are correct.

Neither are correct.

Explanation

Case hasaccurately describedthetwo major differences betweenaccountingincomeandeconomic income.Accounting

depreciationis basedontheoriginal costofaninvestment, whileeconomic depreciationis basedonthe market valueofthe asset.Also,theinterestexpensethatissubtractedfrom accountingincomeisnot considered when computingeconomic

income becauseinterestexpensesareimplicitinthe required rateof returnusedto calculatetheasset's market value.

(21)

Question #3

9 of 62

QuestionID:462555

dedicatedstaffofgraphic designers.

Liuis considering replacing his currentoffsetprinting machine with anew cuttingedgeprinting machinethat wouldallow him

toexpand his range.Thenew machine would cost £200,000and beusedfor afour-year period.If Liudecidedtooptfor the new machinetheold machine could besoldonfor £50,000immediately.If Liudecidesnottogoahead with theprojecttheold

machine would continueto beusedfor thenextfour years beforefinally beingscrappedfor £10,000.

Liuusesstraight-linedepreciationfor tax andaccountingpurposesandassumesnosalvage valuefor accountingpurposes. Theold machine cost £80,000and wasoriginally expectedto havean8 year life.Theold machineisnow 4 yearsoldand has a book valueof £40,000. Liuexpectsthenew machinetoallow him toproducethe8-fold booklets which canfitinstandard sized mailingenvelopes. Liu hasspent £5,000on market research that hasestablishedthatthereisasignificant marketfor

thisproduct.Asa resultofthe machine Liuexpects his yearly salesto be £1,250,000, whereasif he continuedtousetheold

machinesales wouldonly be £950,000per annum.

Naturally Liuexpectsthisincreasein revenuesto haveanimpacton his cost base. Liuexpectsto havetoinvestafurther £40,000in working capitalif hedecidedtoadoptthenew machine.Additionally thenew machine will resultinincremental cash

operatingexpensesof £120,000per annum.

Attheendofitsfour-year operatinglifethenew machine could besoldfor £25,000.

Quik Printz is currently payingtax ata40% rateand hasa costof capitalof15%. Liuassumesthatthenew machine will have similar risk tothefirm and will befundedusingtheexisting mix ofdebtandequity.

Liu makesa coupleof commentsto you regardingtheimpactofinflationon capital budgeting:

Comment1: "In my estimatesofoperating cash flowsI haveincludedtheimpactofinflationon cash flows. SinceI haveused nominal cash flowsI candiscountthem usinga costof capitalthatexcludesinflation,such asa real rate"

Comment2 "Theimpactofinflationonthedepreciationtax shieldisthat, whileitis constantinnominalterms,it'slikely to be

reducedin realterms"

Liualso wantsto consider thestand-a-lone risk oftheprojectand hasdecidedtoundertake MonteCarlosimulation. Liuasks

youto help him clarify hisunderstandingoftheprocessand makestwo comments:

Comment1 "The wholeprocessseemsto bedriven by assumeddistributionsfor each oftheinputsofthe NPV calculation. The resultsIgetfrom MonteCarloarethereforelikely to beaffected by the meanandstandarddeviationthatIassumefor

each of my inputs"

Comment2 "Theprocessof randomly picking valuesfor each inputfrom their associateddistributionis repeated many times

with each simulation beingusedto calculatean NPV.After I've runthesimulation many timesIshouldthen calculatethe mean ofallpossible NPVsandthestandarddeviationaroundthat mean"

What would betheinitialoutlay att=0for the replacementproject?

£194,000 £240,000

£190,000

Explanation

(22)

Question #40 of 62

QuestionID:462556

Question #41 of 62

QuestionID:472515

Tax onold machine (outflow) − £4,000 Working capitalinvestment (outflow) − £40,000 Net cash flow −£194,000

Note:Tax onold machine = 0.4 x (£50,000- £40,000)

(Study Session8, LOS 25.a)

Theafter-tax operating cash flow for year 1isclosest to:

£222,000 £128,000

£124,000

Explanation

After tax operating cash flows:

(S-C)(1-T) + (D x T)

Incremental cash sales-incrementaloperatingexpenses:

£300,000- £120,000 = £180,000 Incrementaldepreciation:

New machine = £200,000/4 = £50,000p.a.

Old machine = £80,000/8 = £10,000p.a. Incrementaldepreciation = £40,000

OCF = £180,000 (1-0.4) + (£40,000 x 0.4) = £124,000

Theterminal year after-tax non-operating cash flow is closestto:

£55,000 £69,000

£49,000

Explanation

Terminalnon-operating cash flows:

(23)

Question #42 of 62

QuestionID:462558

Question #43 of 62

QuestionID:462559

Savedtax onscrapofold machine (inflow) + £4,000 Terminalnon-operating CF £49,000

Note:Iftheprojectisaccepted,theold machineisscrappedatt=0andasa result weforgotheendoflifescrapproceeds

(andany tax issues). Tax onnew machine

(Sales Price-Book value) x 40% (£25,000- £0) x 0.4 = £10,000

Savedtax onold machine

(£10,000- £0) x 0.4 = £4,000

The NPV of Liu's replacementprojectisclosest to:

£109,432 £125,283

£188,033

Explanation

T0 T1 T2 T3 T4

Outlay (194,000)

Operating CF 124,000 124,000 124,000 124,000

TNOCF 49,000

Totals (194,000) 124,000 124,000 124,000 173,000

Regarding Liu'sstatementsaboutinflationand capital budgeting:

Both statements are incorrect

Both statementsare correct

Onestatementis correct

Explanation

Statement1isfalse.Ifinflationisincludedin cash flows (nominal cash flows)thenthediscount rateshouldincludeinflationtoo

(anominaldiscount rate).Ifinflationisexcludedfrom cash flowstheninflationshould bestrippedoutofthediscount rate by

usinga realdiscount rate.

Statement2is correct.Thedepreciationtax shieldis basedonthe historic costoftheassetsandthereforedoesnotincrease

(24)

Question #44 of 62

QuestionID:462560

Question #45 of 62

QuestionID:462538

hasdecreasedin realterms).

(Study Session8, LOS 25.b)

Regarding Liu'sstatementsabout MonteCarlosimulation:

One statement is correct

Both statementsare correct Both statementsareincorrect

Explanation

Statement1is correct.For MonteCarlosimulations, key inputsareassumeddistributionandtheir mean/standarddeviation.

Statement2is correct.Ina MonteCarlosimulation,largenumber ofsimulationsaregenerated with each simulation basedoff of randomly generatedinput variables (from their underlyingassumeddistributions).For each simulation,asinglepoint estimate NPV is computed. We canthe calculatethe mean NPV valueitsstandarddeviation (asa measureof risk).

(Study Session8, LOS 25.d)

KarenFeasey,the Plant Manager ofIndustrialCoatings,istryingtodecide whether to replacetheold coatings machine with anew computerized machine. Her executiveassistantgathersthefollowinginformation:

Company Assumptions:

Tax rate:40%

Weightedaverage costof capital (WACC):13%

NewMachine Assumptions:

Costof (includesshippingandinstallation): $150,000

Salvage valueatendof year 5: $35,000

Depreciation Schedule: MACRS 7-year, with depreciation ratesin years1-5of14%,25%,17%,13%,and 9%, respectively

Purchase willinitially increase currentassets by $15,000and willincrease currentliabilities by $10,000

Impacton OperatingCash Flows Years1-5 (includesdepreciationandtaxes): $28,000 (assumeequalamounteach year for

simplicity)

OldMachine Assumptions:

Sellold machinefor current market value: $25,000

Book value: $15,000

Duringtheprocessof makingthedecision whether or notto replacetheold machine,Feasey calculatestheinitial cash outlay as

(25)

Question #46 of 62

QuestionID:462586

Questions #47-52 of 62

$155,000.

$130,000. $134,000.

Explanation

Theinitialinvestmentoutlay is calculatedasfollows:

costofnew machine + proceeds/lossfrom old machine + changeinnet working capital (NWC) = -$150,000 + $25,000- $4,000- $5,000 = -$134,000 (cashoutflow)

Costofnew machine = $150,000outflow Saleof Old Machine:

Salesprice = $25,000inflow

Tax/tax credit: $4,000outflow

= (Salesprice- book value)*(tax rate) = (25,000-15,000)*0.4

Changein NWC = $5,000outflow

Δ NWC = Δ currentassets- Δ currentliabilities = 15,000-10,000 = 5,000

WandaBrunner,CFA,is workingona capitalproject valuationandneedstodeterminetheappropriatediscount rate. She has thefollowinginformationavailable:

Risk-free-rate = 8% MarketBeta = 1.0 Company Beta = 1.1

ProjectBeta = 1.2

Expected market return = 13%

Trailing12-months market return = 12%

Which ofthefollowingis closesttothemost appropriatediscount rate?

13.5%.

13.0%. 14.0%.

Explanation

Projectdiscount rate = R + β (E(R )− R )

Projectdiscount rate = 8% + 1.2(13% −8%)

(26)

Alias,Inc.isa maker ofplastic containersfor thefoodand beverageindustry.BruceAtkinson,Alias' director ofoperations,is lookingatupgradingthefirm's manufacturing capacity inanefforttoimprovethefirm's competitiveposition.

Atkinsonis beingassisted by Linda Ralston,afinancialanalyst recently hired by Alias. Over thelastthree months, Ralstonand Atkinson have beengoingtotradeshowsand conductingother research ondifferent machinesandprocessesusedinthe plastic container industry. Ralstonestimatesthattraveland hotel costsexpendedasa resultoftheir research amountedto

$8,000.Atkinson considersthe money wellspent because henow hadtwogreatideasfor improvingAlias' competitivenessin theindustry.

ThefirstoftheseideasisthatAtkinsonis considering replacinga bottle blow molding machine.This machine waspurchased for $50,0003 yearsagoandis beingdepreciatedfor tax purposesover 5 yearstoa zerosalvage valueusingstraight-line depreciation.Thefirm has2 yearsofdepreciation remainingontheold machine.

IfAtkinsondecidesto makethe replacement,theold machine can besoldtoday for $10,000.Thenew machine will costthe firm $100,000.Accordingto Ralston'sprojections,thenew machine willincrease revenue by $40,000per year for 3 years but

willalsoincrease costs by $5,000per year.The machine will bedepreciatedover a modifiedaccelerated cost recovery system (MACRS)3-year classlife.Attheendof year 3,theequipment will besoldfor $20,000.Thefirm'stax rateis35%.

Atkinsonisalso consideringaninvestmentinanew silk screenlabeling machinethat canputlabelsonAliasplastic bottlesas partofthe manufacturingprocess. Ralstonestimatesthatthenew labeling machine will cost $50,000,andthatshippingand installation costs will be $7,500.Theadditionofthelabeling machine will requirea $2,000investmentinsparepartsinventory

attheinceptionoftheproject, buttheseparts can be resoldfor $2,000attheproject'send.Compared with the manual processthatAliasusedtousefor puttingonlabels, Ralstonestimatesthatthenew machine will reduce costs by $25,000per year for 4 years.Thelabeling machine will bedepreciatedover a MACRS 5-year classlife.Attheendof year 4,theequipment

will besoldfor $8,000.

Depreciationschedulesunder MACRS areshownintheexhibit below:

Ow

n

e

r

s

h

ip

Y

e

a

r

C

lass

of I

n

ve

s

t

m

e

n

t

3-

Y

e

a

r

5-

Y

e

a

r

7-

Y

e

a

r

10-

Y

e

a

r

1

33 %

20 %

14 %

10 %

2

45 %

32 %

25 %

18 %

3

15 %

1 9%

17 %

14 %

4

7 %

12 %

13 %

12 %

5

11 %

9%

6

6 %

9%

7 %

7 9%

7 %

8

4 %

7 %

9

7 %

10

6 %

11

3 %

(27)

Question #47 of 62

QuestionID:462548

Question #48 of 62

QuestionID:462549

Before makingthefinal calculations,Atkinsonand Ralstondiscussnetpresent valueanalysisfor theprojectsthey are

considering. RalstontellsAtkinson, "when calculatingthenetpresent valueofthetwonew projects, wealsoneedtoaccount for the costsexpendedasa resultof researchingtheprojectoptions." Atkinson makesanoteon hislegalpadandsaysto

Ralston, "Thereisnoneedto makeany adjustmentsfor inflationinour estimationsoffutureproject cash flows because inflationisincludedaspartoftheexpected returnsusedto calculateour weightedaverage costof capital." After their conversation, RalstonandAtkinsonpreparetheir reporttopresenttoAlias' CEO.

Theinitialinvestmentoutlay for purchasingthenew bottle blow molding machineisclosest to:

−$90,000.

−$86,500. −$100,000.

Explanation

Theinitialoutlay isthe costofthenew machine minusthe market valueoftheold machineplus/minusany tax consequences thatarisefrom sellingtheold machine.Thenew machine's costis $100,000.

Theold machine can besoldfor $10,000, however consideringthatthe machine'sinitial cost was $50,000and has3 yearsof accumulatedstraight-linedepreciation,the book valueoftheold machineis $50,000− (3 × 10,000) = $20,000.This means thatthesaleofthe machine will resultina (10,000−20,000) = −10,000loss.Theloss will resultintax savingsfor Aliasequal to0.35 × 10,000 = $3,500.

Thetotalinitialinvestmentoutlay for thenew machineis:

−

$

100,000

+

10,000

+

3,500

=

−

$

8

6 ,500

The year 1operating cash flow for thenew bottle blow molding machineisclosest to: $34,300.

$30,800.

$22,750.

Explanation

Theoperating cash flowsequaltheafter-tax benefitplusthetax savingsfrom depreciation.Inthe caseofa replacement project, you musttakethedifference betweentheadditionaldepreciationfrom thenew asset minusthelostdepreciationfrom

theoldasset.Thefirm gaveup $10,000per year for ofdepreciationontheoldassetfor years1and2ofthenew asset'slife.

CF1

= (r

e

v

enue

−

c

ost)1

× (

1 −

ta

x r

ate)

+

net

dep

r

e

c

iation1

× (

ta

x r

ate)

((

40,000

−

5,000)

×

0.

6 5)

+ [((

0.33 ×

100,000)

−

10,000)

× (

0.35)

] = $

30,800

(28)

Question #4

9 of 62

QuestionID:462550

Question #50 of 62

QuestionID:462551

Question #51 of 62

QuestionID:462552

ᅞ A) ᅚ B)

Thetotal cash flow from the bottle blow molding machinein year 3isclosest to: $28,000.

$43,450.

$48,000.

Explanation

Thetotal cash flow for theterminal year isequaltotheoperating cash flow plusthenon-operating (or terminating) cash flow. Theoperating cash flow equals:

CF3

= (r

e

v

enue

−

c

ost)3

× (

1 −

ta

x r

ate)

+

net

dep

r

e

c

iation3

× (

ta

x r

ate)

((

40,000

-

5,000)

×

0.

6 5)

+ [((

0.15 ×

100,000)

−

0)

×

0.35)

] = $

28,000

Thenon-operating cash flow equalsthe marketor salvage valueplus/minustax consequencesofsellingit.Thenew machine

will besoldfor $20,000.The book valueafter 3 yearsofdepreciationis $100,000 × (1.00-0.33-0.45-0.15) = $7,000. So, thegainequals $20,000- $7,000 = $13,000.

Thefirm willpay taxesonthegainof:

13,000

×

0.35 = $

4,550

Totalterminal year cash flow = $28,000 + $20,000- $4,550 = $43,450

Note: Once we havetheproject'sestimated cash flows,thenextstepintheprocess would beto calculatethenetpresent

valueandinternal rateof returnfor theproject. (Study Session7, LOS 22.a)

Theinitial cash flow for thelabeling machineisclosest to:

−$50,000.

−$57,500. −$59,500.

Explanation

Theinitialoutlay isthe costofthelabeling machine,theshippingandinstallation costs,andtheincreaseinnet working capital

(inthis casetheincreaseinsparepartsinventory):

(−$50,000) + (−$7,500) + (−$2,000) = −$59,500.

The year 2operating cash flow for thelabeling machineisclosest to: $21,040.

(29)

ᅞ C)

Question #52 of 62

QuestionID:462553

Question #53 of 62

QuestionID:462582

Question #54 of 62

QuestionID:462601

$34,650.

Explanation

Theoperating cash flowsequaltheafter-tax benefitplusthetax savingsfrom depreciation.

CF2

=

Benefit2

× (

1 −

ta

x r

ate)

+

dep

r

e

c

iation2

× (

ta

x r

ate)

($

25,000

×

0.

6 5)

+ ($

57,500

×

0.32 ×

0.35)

= $

22,

69

0

Notethattheshippingandinstallation costsarepartofthedepreciable basisfor the machine. (Study Session7, LOS 22.a)

With regardtothe conversation between RalstonandAtkinson concerning NPV analysis: Ralston's statement is correct; Atkinson's statement is incorrect.

Ralston'sstatementisincorrect; Atkinson'sstatementisincorrect.

Ralston'sstatementisincorrect; Atkinson'sstatementis correct.

Explanation

The hotelandtravel costsexpendedto research theprojects would beexpended whether Aliasdecidedtotakeonthe projectsor not.The research costsareasunk cost, which isa cash outflow that haspreviously been committedor hasalready

occurred. Sincethese costsarenotincremental,they shouldnot beincludedaspartoftheanalysis.Therefore Ralston's statementisincorrect.

Atkinson'sstatementisalsoincorrect.Although itistruethattheexpectedinflationis builtintotheexpected returnsusedto

calculatethe weightedaverage costof capital,Atkinsonand Ralstonstillneedtoadjusttheproject cash flowsupwardto accountfor inflation.Ifnoadjustmentsare madetotheproject cash flowstoaccountfor inflation,the NPV will be biased downward. (Study Session8, LOS 25.g)

Which ofthefollowingstatementsabout MonteCarlosimulationisleast accurate? MonteCarlosimulation:

is the most accurate risk analysis tool because it is based on real data. can beusefulfor estimatingthestand-alone risk ofaproject.

is capableofusingprobability distributionsfor variablesasinputdata.

Explanation

MonteCarlouses computer simulateddatanot realdatatoestimate risk.It can bea very usefultool whenthereisa very

smallsamplesizefor analysis.

(30)

o-ᅞ A) ᅚ B) ᅞ C)

Question #55 of 62

QuestionID:462583

ᅞ A)

ᅞ B)

ᅚ C)

Question #56 of 62

QuestionID:414792

ᅞ A) ᅚ B)

year life with nosalvage value.Theproject willgenerateoperatingearningsof 130 millioneach year for thetwo years.The Firehouse's weightedaverage costof capitaland required rateof returnfor theprojectis10%.Firehouse'stax rateis30%.

WhatisFirehouse'seconomic profitfor years1and2? Year 1 Year 2

42 22

61 76

-20 -20

Explanation

Notethatthis questionisaskingabouteconomic profit,noteconomic income.

Economic profitis calculatedas NOPAT- $WACC = EBIT(1-T)- $WACC

NOPAT = EBIT (1-Tax Rate) = 130 (1-0.3) = 91

$WACC Year 1 = 0.10 × 300 = 30

$WACC Year 2 = 0.10 × 150 = 15

Economic profit (Year 1) = 91- 30 = 61

Economic profit (Year 2) = 91- 15 = 76

Which ofthefollowingstatementsabout risk analysistechniquesisleastaccurate?

Scenario analysis is a risk analysis technique that considers both the sensitivity of the dependent variable to changes in the independent variables and the range of likely values of these variables.

Sensitivity analysisisincomplete, becauseitfailsto consider theprobability distributionsof theindependent variables.

Insensitivity analysis,thedependent variableisplottedonthe y-axisandtheindependent variableonthe x-axis.Thesteeper theslopeonthe resultinglinethelesssensitivethe dependent variableisto changesintheindependent variable.

Explanation

Insensitivity analysis,thedependent variableisplottedonthe y-axisandtheindependent variableonthe x-axis.Thesteeper theslope onthe resultinglinethemoresensitivethedependent variableisto changesintheindependent variable.

If central bank actions causedthe risk-free ratetoincrease, whatisthemost likely changeto costofdebtandequity capital?

One increase and one decrease.

(31)

ᅞ C)

Question #57 of 62

QuestionID:462566

ᅞ A)

ᅚ B) ᅞ C)

Question #58 of 62

QuestionID:462565

Question #5

9 of 62

QuestionID:462539

Both decrease.

Explanation

Anincreaseinthe risk-free rate will causethe costofequity toincrease.It wouldalso causethe costofdebttoincrease.In either case,thenominal costof capitalisthe risk-free rateplustheappropriatepremium for risk.

NorineBensonisstudyingfor the LevelICFAexaminationandis havingdifficulty with the broader conceptsof capital

budgeting. Her study partner, Henri Manz,tests her understanding by asking her toidentify which ofthefollowingstatements ismost accurate?

An analyst can ignore inflation since price level expectations are built into the

weighted average cost of capital (WACC).

Replacementdecisionsinvolve mutually exclusiveprojects.

For mutually exclusiveprojects,thedecision ruleistopick theprojectthat hasthe

highestnetpresent value (NPV).

Explanation

Because replacementdecisionsinvolveeither keepingtheoldasset or replacingtheoldasset,theprojectsare mutually

exclusive.

Thedecision rulefor NPV istopick theproject with the highestpositive NPV. Only projects with positive NPV addtothe

company's value.Ifneither project hasapositive NPV,neither projectshould be chosen.Becausethe WACCisadjustedfor

inflation,theanalystmust adjustproject cash flowsupwardto reflectinflation.Ifthe cash flowsarenotadjustedfor inflation, the NPV will be biaseddownward. (Reversetheprecedinglogic for deflation.)

With respectto capital budgetingand measuringnetpresent value,toavoid biasesfrom anincreaseinexpectedinflation,an analystshould revise:

weighted average cost of capital (WACC) down and cash flows up. weightedaverage costof capital (WACC)upand cash flowsdown.

both weightedaverage costof capital (WACC)and cash flowsup.

Explanation

Required ratesof returnoninvestmentsgenerally exceedinflation.Anincreaseinexpectedinflation willgenerally increasethe

required returnonequity anddebt; therefore,the WACC will riseasinflation rises.Toavoidadownward biasonnetpresent

(32)

Question #60 of 62

QuestionID:462595

Question #61 of 62

QuestionID:462568

Giventhefollowinginformation, whatistheinitial cash outflow? Purchasepriceofthenew machine $8,000

ShippingandInstallation charge $2,000

Salepriceofold machine $6,000 Book valueofold machine $2,000 Inventory increasesifinstalled $3,000 Accountspayableincreaseifinstalled $1,000 Tax rateonCapital Gains 25%

-$7,000. -$10,000. -$3,000.

Explanation

-$10,000for purchasepriceplusshippingand handling costs

+ 6,000from cash saleofold machine

- 1,000for capitalgainstaxesonold machine [(6,000-2,000)*.25]

- 2,000 cash outflow for changein Net WorkingCapital (-3,000Inv+1,000AP)

-$7,000

Which ofthefollowingexpressionsistheleast accurate calculationfor economic income?

Economic income =cash flow - (beginning market value - ending market value). Economic income = cash flow -dollar weightedaverage costof capital.

Economic income = cash flow + changein market value.

Explanation

Economic incomeisdefinedastheafter tax cash flow plusthe changein market valueofaninvestment.The changein

market value canalso beexpressedaseconomic depreciation. Notethatthedollar weightedaverage costof capitalisaterm

associated with economic profit, which isadifferent conceptfrom economic income.

Afirm isunableto raisethenecessary fundingfor allprojectsthat havepositiveexpectednetpresent values.Therefore,thisfirm must:

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Question #62 of 62

QuestionID:462591

ᅞ A) ᅚ B) ᅞ C) Explanation

Whenafirm isunabletofundallprojectsthat havepositiveexpectednetpresent values,thefirm mustengagein capital rationing.

Rachel Moore,ananalyst with DawsonCorporation,isdiscussingapotential capitalproject with her colleague, PhillipCora. Theprojectinvolvesproducinganew productthat will besoldindiscount retailstores.Ifsalesfor thenew productare favorable,Dawson hastheability topurchasenew equipmentfor theexistingproductionfacility that willexpandproductionto doubleits current rate. However, Mooreis concernedthatother companies may easily replicatetheproductandthatlow barrierstoentry will reduceDawson'sprofitability.Ifsalesfor thenew productaredisappointingafter thefirsttwo years, Dawson hasapotential buyer that willpay $2 millionfor theproductionfacility. MooreexplainsthesefactstoCoraandasks

him for helpin computinganaccuratenetpresent value (NPV)for theproject.Cora replies with thefollowingstatements:

Statement1: You cannot computeadollar valuefor theprojectthatincludes both theexpansionoptionandtheabandonmentoption,sinceonly oneofthem canactually beexercised.

Statement2: Since youdonot haveany controlover whatisgoingonatother companies, youshouldnotfactor inthe creationof competing productsfrom other companiesinto your analysis,andfocustotally ontheincremental cash flowsgeneratedfrom our productionof theproduct.

How should Moore respondtoCora'sstatements?

Agree withboth

Agree with neither. Agree with oneonly.

Explanation

Mooreshoulddisagree with both ofCora'sstatements. Eventhough both theoptiontodoubleproductionandtheoptiontosell theproductionfacility cannot beexercisedsimultaneously,they both add valuetotheprojectandshould be both be

consideredinany analysis. Evenifitisdifficultto computeanexactdollar valuefor each option's contributiontotheproject,

Moore can computethe valuefor theproject withouttheoptions,andiftheprojectdoesnotalready haveapositive NPV,she

canestimate whether theoption valuesareenough to makethe NPV positive.Cora'ssecondstatementisalsoincorrect.The